All pop and no fizz for Pepsi! PepsiCo files to appeal federal court’s decision in relation to its intangible arrangement

The concentrate was produced by Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL), a Singaporean member of the PepsiCo Group, according to a secret formula provided by PepsiCo and SVC. CMSPL supplied the concentrate to PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian entity, nominated by PepsiCo or SVC. PBS then supplied the concentrate to SAPL and received payments totalling around A$240 million, which PBS transferred to CMSPL after deducting a small margin. Both CMSPL and PBS were not parties to the EBAs with SAPL.

The Court’s decision

Were the payments made by SAPL under the EBAs “royalties” for RWHT purposes?

Court’s decision – Yes

The Court, referring to Article 12 of the United States – Australia Double Tax Agreement (US-AUS DTA) and section 6(1) of the ITAA 1936, was tasked with determining whether the payments made pursuant to the EBA by SAPL were subject to RWHT under section 128B of the ITAA 1936. The threshold issues considered by the Court are summarised below:

1.  Were the EBA payments consideration for the use, or right to use, the relevant licensed IP? 

PepsiCo and the Commissioner did not dispute that the relevant IP (being key trademarks and other IP) licensed to SAPL under the EBAs fall within the description of “relevant items” under Article 12 of the US-AUS DTA and section 6(1) of the ITAA 1936.

The question instead was whether the payments made pursuant to the EBAs were consideration for that licenced IP, rather than just for the concentrate as PepsiCo and SVC were contending.

The Court stated it all comes down to a matter of characterisation of the payments based on the relevant terms of the EBAs themselves, but also consideration of those terms in their business and commercial context. Stating, that the latter is to give effect to the purpose of Article 12 of the US-AUS DTA of identifying the taxing rights for certain payments that are, in their business and commercial context, consideration for the use of, or the right to use, the relevant items listed in that article. The Court’s view was that such a purpose is evident by the wording of Article 12 and section 6(1) of the ITAA 1936, which states that payments may be consideration for the relevant items “regardless of how the payments are described” by the parties to a transaction.

On that basis, the Court found that the way the payments are described by the parties under the EBAs (in SVC’s case, as explicitly “royalty free”) is not determinative of whether the payments are consideration for the licensed IP.

Instead, the Court concluded the following features (among others) of the EBAs supported the conclusion that the payments made under the EBA was consideration for the use of, or the right to use, the licensed IP:

• The parties to the EBA was PepsiCo and SVC (i.e. the owners of the trademarks and IP). The seller of the concentrate was not a party to the EBAs.
• The EBAs contained a licence by PepsiCo or SVC of the relevant trademarks and other IP to SAPL, including an implied licence in PepsiCo’s case and an express licence in SVC’s case.
• The licence of the trademarks and IP was fundamental to the EBAs. SAPL would not have been able to package and sell the beverages under the respective brands without it, with the Court stating it may be inferred that SAPL would not have agreed to make the payments without the licence of the relevant trademarks and other IP.
• The payments made by SAPL was linked to the licence of trademarks and IP provided by the EBAs.

The Court’s analysis here will likely stir up an emerging debate regarding the extent “business and commercial context” of contractual terms ought to drive the Court’s construction of the nature of an arrangement, as opposed to the actual written contractual terms agreed upon by the parties. Keeping in mind we have recently seen similar arguments play out in relation to employment contracts, albeit clearly in a different legislative setting.

2.  If the payments were “consideration for” the relevant IP, was it income derived by PepsiCo or SVC, and were they beneficially entitled to that payment?

The Court considered whether the payments were derived by PepsiCo or SVC under section 128B(2B)(a) of the ITAA 1936, concurrently with its assessment of whether PepsiCo or SVC were beneficially entitled to those payments for the purposes of Article 12 of the US-AUS DTA.

The Court concluded that PepsiCo and SVC were ultimately entitled to receive the payments made by SAPL pursuant to the EBAs. This is because they are the parties to the EBAs, and SAPL’s payment obligation under the EBAs was owed to them. The fact that PepsiCo and SVC directed SAPL to pay PBS instead (being the entity which sold the concentrate to SAPL) did not change that entitlement, particularly as PBS was, and has, never been a party to the EBAs.

Because PepsiCo and SVC “directed” SAPL to make the payments owed to them under the EBAs to PBS, that direction serves as evidence of the payments “coming home” to PepsiCo and SVC. Which, as the Court determined, can be regarded as the payments being derived by PepsiCo and SVC. For the same reason given above, the Court concluded that PepsiCo and SVC were also beneficially entitled to the payments made pursuant to the EBAs as well.

3.  Were the payments “paid to” PepsiCo or SVC?

The Court considered whether, for the purposes of section 128B(2B)(i) of the ITAA 1936, the royalty was paid to PepsiCo and SVC by SAPL. As relevant to the current matter, section 128A(2) of the ITAA 1936 states that a royalty is deemed to have been paid, even if it is not actually paid, if the royalty is otherwise dealt with on behalf of the other person (i.e. PepsiCo and SVC) or as they direct.

The Court outright rejected the submissions made by PepsiCo and confirmed, based on its analysis in the two issues above, that PepsiCo and SVC were entitled to receive the payments under the EBAs, and has directed/nominated those payments to be made to PBS instead. Those factors satisfied section 128A(2) of the ITAA 1936.

Lastly, the Court also spent a considerable amount of time reviewing the expert witness evidence in relation to determining the amount of the royalty payable. It ultimately selected a comparable uncontrolled price method proposed by both experts, whereby comparable licence agreements entered between independent parties under comparable circumstances are selected to perform a benchmarking exercise to price the IP licensed under the EBAs. However, the Court ultimately agreed with the expert witness evidence of the Commissioner, citing that witness’ experience being most relevant to the matter.

If the payments made by SAPL under the EBAs do not constitute “royalties”, do the DPT provisions instead apply?

Court’s decision – Yes

In short, under the DPT regime, the Commissioner may impose tax at a penalty rate of 40% on the ‘diverted profit amount’ on significant global entities for schemes carried out for a “principal purpose” of obtaining an Australian tax benefit, when that taxpayer obtains a tax benefit from the scheme.

The Court held that, had it not concluded RWHT applied, then the DPT provisions would apply to PepsiCo and SVC for the following reasons:

1.  What was the scheme?

The Court accepted the two schemes relied on by the Commissioner as required under Part IVA of the ITAA 1936, where in each case, the scheme was entry into the relevant EBAs on terms whereby no royalty was paid for the use of the relevant trademarks and other IP.

2.  Did PepsiCo and SVC obtain a tax benefit?

Section 177C(1)(bc) of the ITAA 1936 (as elaborated by section 177CB) requires a counterfactual analysis to determine if PepsiCo and SVC obtained a tax benefit i.e. what would have happened or might reasonably be expected to have happened if the scheme had not been entered into or carried out.

The Commissioner put forward two counterfactuals, which it contended, had the relevant scheme not been entered into or carried out, then:

• the EBAs would or might reasonably be expected to have expressed that the payments to be made by SAPL was for all of the property provided by the PepsiCo group (i.e. trademarks, other IP and concentrate, rather than just concentrate); or
• the EBAs would or might reasonably be expected to have expressed that the payments to be made by SAPL was to include a royalty for the use of, or the right to use the relevant trademarks and other IP.
  The Court correctly pointed out that the Commissioner's formulation of the two counterfactuals, namely the inclusion of the phrase “would or might reasonably,” was inconsistent with the operation of section 177CB(2) of the ITAA 1936.

Namely, the provision distinctly outlines two limbs in the counterfactual analysis. Counterfactuals expressed with the term "would have occurred" must be based on a counterfactual that encompasses only the events or circumstances that actually happened or exist (referred to as the annihilation approach). Therefore, since the Commissioner's two counterfactuals involve events or circumstances that did not actually happen, the use of the words "would have" in formulating those counterfactuals is inaccurate.

On that basis, the Court concluded the counterfactuals will solely be assessed under the "might reasonably be expected" limb of section 177CB(2) of the ITAA 1936. The Court ultimately accepted the Commissioner’s first counterfactual for the following reasons:

• the substance of the counterfactual was the same as the EBAs. In particular, when taking into consideration the commercial and economic substance as distinct from its legal shape and form;
• the financial and other consequences for PepsiCo and SVC of the counterfactual was comparable to that of the EBAs; and
• the licence of trademarks and other IP was a fundamental feature of the EBAs.

 3.  Was one of the principal purposes for entering into the scheme to obtain the tax benefit?

This “principal purpose” test under the DPT provisions intentionally lowers the evidentiary hurdle of the “sole and dominant purpose” test contained in the general anti-avoidance rules in Part IVA of the ITAA 1936. Specifically, “obtaining a tax benefit” only needs to be one of the prominent, leading or main purposes for entering the scheme.

The Court concluded that, having regard to section 177J of the ITAA 1936, at least one of the principal purposes of PepsiCo and SVC entering the scheme was to obtain a tax benefit, highlighting the following reasons:

• While the Court accepted that the EBAs generally replicated the standardised franchised owned bottling operations (FOBO) model that had been around since the early 1900s, it pointed to the lack of detailed evidence about “the manner in which the scheme was entered into or carried out.” Being, the negotiations of the EBAs in 2009 when they were signed, and why the PepsiCo Group decided to adopt that pricing structure. Therefore, the Court could not entirely rule out tax considerations as a reason for entering the EBAs.
• The Court considered there was a disconnect between the form and substance of the agreement i.e. the EBAs provided for a payment of the concentrate alone, while in substance the payments included for the concentrate and for trademarks and other IP. Following the case in Federal Commissioner of Taxation v Macquarie Bank Ltd, this disconnect supports the presence of a “tax benefit” purpose for entering the scheme. The Court also pointed to the fact that the trademarks licenced were highly valuable.
• While PBS paid tax in Australia on the amount earned from selling the concentrate it bought from CMSPL to SAPL, the concentrate was priced in a way resulting in PBS earning a very small margin in Australia, and so remitting limited tax. It was also noted that CMSPL is incorporated and taxed in Singapore, a low tax jurisdiction, so it was likely that little tax was paid on the payments made under the EBA.

Prior to 31 December 2017, any royalty that would have been paid to PepsiCo and SVC in the United States would have been subjected to tax at 35% (with a tax offset likely available for any RWHT paid in Australia), and so the scheme would have achieved a reduction in US tax for PepsiCo and SVC for the period before 31 December 2017.

While the RWHT that would have been payable under the counterfactual is not large in the context of the total payments made under the EBA, the fact that PepsiCo and SVC would have been liable to pay it still supports the presence of a “tax benefit” purpose for entering the scheme.